GE under siege (pg. 2)
Unhappily, the causes of that first-quarter debacle haven't disappeared. GE's managers, like everyone else, failed to foresee how bad things could get in today's vast, interlocking financial system. Managers thought they were being bold in stress-testing their model against a percentage-point jump in rates, but didn't conceive of a sudden and nearly complete stop to interbank lending, a total absence of buyers for some securitized debt, and investors so panicked they're willing to accept negative interest rates to gain the safety of T-bills. In that world even GE Capital's business model doesn't work the way it's supposed to.
Bad news piled up through the summer. GE had announced it would sell its businesses that make light bulbs, appliances, and certain electrical equipment (yes, the company founded by Thomas Edison wanted out of light bulbs); profits were piddling and unlikely to improve in these commodity-like businesses. But it was too late. In a slowing economy no one would pay a respectable price. GE also wanted to sell its private-label credit card business, but again - too late. In traumatized credit markets, no one wanted to buy $30 billion of credit card receivables, much of which was owed by subprime borrowers, according to company statements. So GE is still stuck with those businesses.
The stock, which had been around $40 a year ago, drifted down into the 20s over the summer before collapsing in mid-September as the financial crisis entered its acute phase with the failure of Lehman Brothers.
Immelt, wanting to avoid another disastrous earnings surprise (and escape getting shot by Welch), announced five days before the quarter's end that profits would be lower than previously forecast by about $700 million. Yet that's also when he set the stage for a different jolt to investors by saying he foresaw no need to sell new equity. Six days later he sold new equity.
The desperation of that move is even greater than its unseemly haste may suggest. Remember the importance GE attaches to acquiring low-cost capital. Equity is not low-cost - it's more expensive than debt - and the special preferred shares issued to Buffett carry a 10% coupon, which is paid out of after-tax profits. So that $3 billion was about the most expensive capital it's possible to get. But Immelt, who has journeyed to Omaha for meetings with Buffett and has consulted him often, was willing to pay a steep price for the reassurance the famed investor's endorsement would bring. He and CFO Keith Sherin also agreed to hold at least 90% of their personal GE stock until Berkshire's preferred shares are redeemed (Immelt had long ago promised never to sell a share in any case).
There was further evidence of the company's dire state in the stock offering: Until late September, GE had been buying back its own shares on the open market. Last year it bought about $14 billion of them and this year over $1 billion, all at prices in the 30s. Now, just six days after suspending the repurchase program, it was selling $12 billion of shares to the public at about $22. That is, it was buying high and selling low.
Why was it so desperate for cash? The company offers only the blandest reasons for its move, but investors were clearly worried that commercial paper was an important factor. Commercial paper is how corporations borrow for short periods, typically just a few days, for immediate purposes; it's attractive because companies borrow only what they need, and interest rates are low. Lots of firms use commercial paper, frequently just for paying day-to-day bills, but no company uses it anything like GE. GE Capital alone has about $74 billion of commercial paper outstanding; the next largest player, J.P. Morgan, has about $47 billion. GE understood there was risk in relying so heavily on this source of funding but believed it was well prepared for any disruption through access to other sources, such as bank lines of credit.
On the morning of Oct. 1, the markets swirled with rumors that GE couldn't roll over its commercial paper coming due. Like so much else that has happened in recent weeks, this possibility would have seemed outlandish just a month before; a spokesman insists the company has experienced no such problems. But in light of GE's huge commercial paper obligations and the disruption of global credit markets, the rumors became just barely plausible. That's when the stock suddenly dropped 10%, and the price of GE credit default swaps jumped. Regardless of how realistic the market's fears were, the episode puts the Fed's decision five days later to backstop the commercial paper market in a new light, as a signal of support for the commercial paper market's biggest player.
Which leaves GE where? All the bad news in its recently lowered full-year profit forecast is in GE Capital; its profits should fall by 20% to 25% from last year's. The other side of the company, the part most people think of when they think of GE, hasn't shown signs of deterioration, at least not yet. Power turbines, locomotives, jet engines, CT scanners - the world still wants lots of those, and the profits they produce at GE are still rising strongly. Of course, should the financial crisis spark a widespread recession, virtually all of GE would suffer.
What's not in doubt is that GE Capital will be changed profoundly by these events. Immelt has announced a goal of "resizing" GE Capital so that it accounts for just 40% of total GE earnings (down from 46% last year), but that may be making a virtue of necessity. It appears he'll reach his goal next year with no problem whatever. The company's big problem now is that investors just don't know how the galloping financial crisis will affect GE. For example, the company holds some $53 billion of off-balance-sheet assets that are pieces of securitized debt, some of which are hooked to interest rate swaps with counterparties that are now troubled, such as ABN Amro, owned by Fortis and RBS Group. Individually, none of those is enough to cause a major problem. But investors are justifiably spooked by the poorly understood web of connections interlocking global financial firms, which have caused such havoc over the past month, and they're unsure how GE might ultimately be affected.
Another example: GE Capital says that some of the debt it holds is extra-safe because it's covered by credit insurance. But in today's environment, how reliable are the credit insurers?
Investors worry also because GE Capital oversees one of the world's largest commercial real estate portfolios. Tom Shapiro of GoldenTree InSite Partners, a real estate investment firm, says commercial property values have declined 10% to 20% in some regions and are still falling. In addition, GE's portfolio includes residential-mortgage-backed securities, some with subprime exposure, for which there's virtually no market now. More uncertainty for investors.
Another concern is that the leverage in GE could be much higher than stated. Egan-Jones, an independent rating agency, calculates that GE is levered ten-to-one, a more conservative and higher number than the company's eight-to-one figure. Cofounder Sean Egan believes that, depending on the off-balance-sheet holdings, actual leverage could be still higher. His firm rates the company single-A.
In addressing these many uncertainties, Immelt has hammered home the message of GE's commitment to its sacred triple-A rating. He took several steps to conserve capital, such as deciding not to increase the dividend next year and suspending the stock buybacks; Moody's (in which Buffett's Berkshire Hathaway is the largest shareholder) and Standard & Poor's immediately reaffirmed their ratings on the company.
But Immelt may be fighting a battle that investors no longer care so much about. The credibility of bond ratings in general tumbled when it was revealed that securitized subprime mortgages had been rated double- or triple-A. GE's rating clearly meant nothing to investors who bid credit default swaps on company bonds up to a price of 700 basis points (the price subsided recently to about 500). Remember, triple-A means creditworthiness on a par with that of the U.S. Treasury, and credit default swaps on Treasury bonds have never traded above 35 basis points. The message of the markets: The rating agencies can say what they like; we'll decide for ourselves.
Recent events raise the question of whether Immelt's job is safe. The stock is down by half since he took over in September 2001, one reason the company has lost a number of excellent executives. A source close to the board says it still supports him, and he has done a good job of involving directors in major decisions. They regard the present crisis as a 100-year flood that Immelt is managing about as well as anybody could.
He may take solace in the story of Reg Jones, GE's chief from 1972 to 1981. The stock, adjusted for inflation, went nowhere during his tenure. But it was a terrible era for stocks generally, and just before he retired, Fortune asked the Fortune 500 CEOs to name the company and the CEO they admired most. The winners were GE and Jones.
Whether Immelt and GE can ride out the current crisis with their reputations intact is unknowable at the moment. But given that the company is a microcosm of the world's economic health, we'd all better hope that they can.